European bank-stress-test results were announced last week. The good news: only 13 out of 130 banks didn’t make passing grades. The bad news: this test says nothing about how well or badly these banks may do as going concerns in times of stress.

According to the New York Times, “the European Central Bank said its analysis was intended to strengthen banks’ balance sheets, improve transparency in reporting and persuade investors that these institutions are sound.”

This intent would have some credibility if before 2008 regulators had pointed out the banks that were not sound and then if some of them failed during the crisis. But there were no such judgments implying that no one could tell before the crisis which banks were sound and which were unsound.

Bank failures generally come as a surprise in crises. This is because today’s assessment of the soundness of banks is based upon so many subjective assumptions that it fails to prepare banks for the surprises extreme crises bring. The weakest link in the way current stress testing is done is the assigning of values to assets. In relation to the survival of banks in crises, it is a meaningless exercise. This is because no one knows what value these assets will have during crises. What compounds this problem is that such values-in-crisis are assigned during normal times when it is hard to envision a crisis environment.

In a conversation a couple of years ago, a senior risk manager at a large financial institution said that no one had foreseen before 2008 that the value of some the mortgage-related assets would be down by 10-15%. Everyone thought, he said, that a 5% loss would be the maximum deterioration. Actual loss turned out to be more than 20%.

So today’s stress testing is designed with the last crisis in mind. Actual results may turn out to be not as bad as assumed in such testing in some areas considered critical, but some other surprise that no one had thought of may doom institutions.

Yesterday’s Wall Street Journal carried a story: “Fed Tells Banks to Shape Up or Break Up.”. Even though the story does not specifically talk about the financial risk, it implies that banks are not doing enough to address regulators’ concerns. And addressing risk has been a significant concern since 2008. So if you combine it with their concerns that bank models almost always understate their capital requirements, it leads to a lack of trust and confidence, and may be even to mistrust.

Even if banks do all they can, there will always be a confidence gap because the current approach to managing risk can never cover the entire spectrum of risk. The problem arises because no one knows nor can define how much of the risk spectrum is not covered. And as long as there is an uncovered portion of the spectrum, banks are vulnerable. Such vulnerabilities will come to light only when the next crisis arises. Combined with the fact that risk models are too complex to follow and understand easily, there is no way to tell if the portion of the spectrum that is addressed has been done correctly or effectively. Thus banks are not only vulnerable but also no one knows how vulnerable, and whether this vulnerability is acceptable. This is the root cause of the confidence gap.

What is needed is a transparent approach that addresses the entire spectrum of risk that can be easily grasped. (See “What Stress Testing is Not”). Until this is addressed, the current approach to risk will always fall short and there will remain a confidence gap.

By Karamjeet Paul (Published by American Banker/BankThink September 25, 2014)

The financial services industry is often caught in a debate about whether it faces too much regulation or not nearly enough. This is a valid topic of discussion. But it distracts from another, even more critical matter: regulations in the aftermath of the most recent financial crisis have failed to effectively address the root problem that caused so many bank failures.

For the first time in history, regulators are requiring financial institutions to have a specific amount of liquid assets on hand to withstand a 30-day run by creditors and depositors, should a sudden crisis strike again. This is a right step to keep the system from freezing as happened in 2008.

However, will focusing on liquidity prevent what can devastate institutions in crises as experienced by Bear Stearns, Lehman and Wachovia? No, it will not, because institutional liquidity problems in crises are caused by a more fundamental factor.

The big news this week is that large banks will be required to have a higher level of capital in the form of a surcharge amount of capital.

The Wall Street Journal reported on September 9, 2014 (“Fed to Hit Bog Banks With Stiffer Surcharge”) that the new requirements are “aimed at reducing the risk …” and the required increase in capital would be “calibrated to the relative riskiness of the bank as measured by a series of factors.”

Large banks, or may be most banks, may very well need more capital. But this need for capital has not been tied directly to what causes the need for capital in the first place. Some of these “series of factors” aren’t necessarily a measure of what creates the capital requirement.

Capital is needed to cushion unexpected losses arising from extreme-tail risk, which carries the exposure that can result in devastations in extreme crisis. Therefore, the amount of the capital need should be driven by an explicit measure of extreme-tail risk. Unless an objective and transparent measure of extreme risk is used, proposals often lead to the use of factors that are not necessarily connected to extreme risk.

An example, as reported by the WSJ: “One new wrinkle in the Fed’s plan is to tie the size of the surcharge to a bank’s reliance on short-term financing …” The use of short-term financing creates liquidity risk, which matters in a crisis only if extreme-tail risk is perceived to be excessive. It doesn’t create extreme-tail risk. So a surcharge for this factor will have no bearing to the need for capital to deal with extreme risk in crises.

Unless, extreme-tail risk is addressed explicitly, a higher amount of capital will not accomplish what the Fed is trying to do. According to William Coen, Secretary General of the Basel Committee on Banking Supervision, “The answer isn’t simply to say you need another X basis points in capital. Maybe the better response is to require the bank to present a detailed plan on how it’s going to better manage these risks and to make sure the bank sticks to that plan.”

The debate about capital adequacy in the banking industry is not new. Those who have been in the industry long enough know that it has been around for at least 30-40 years. To date, the industry has resisted any change to the status quo, with a result that in the post-2008 world, regulators will define the needed change using subjective measures and opinions backed by the Dodd-Frank Act provisions. Such an approach will actually make banks more vulnerable than stronger in crises.

Lets face it. The status quo, as rationalized currently, is unacceptable. So either the capital requirement has to change or a new rationalization is needed. Rather than fighting or struggling to cope with the regulatory proposal, the industry must proactively come up with an objective approach to capital adequacy rationale that gets to the root of the problem.

I believe the use of an objective and simple measure like “Probable Maximum Loss,” along with an explicit focus on extreme-tail risk, can bring objectivity to this discussion and help make banks and the financial system stronger. As part of the suggestion by Mr. Coen, regulators should insist, and institutions on their own should develop effective plans for extreme-tail risk.

With banks getting ready for the year-end regulatory stress testing, it is worth looking at what stress testing is and, more importantly, what it is not.

Typically, stress-testing models simulate adverse conditions to evaluate if a system/structure can survive abnormal circumstances. For banks, the objective of regulatory stress testing, also known as Comprehensive Capital Analysis and Review (CCAR), is “to assess whether the largest bank holding companies operating in the United States have sufficient capital to continue operations throughout times of economic and financial stress …”

Passing CCAR is important as low grades create a negative perception and accompany regulatory restrictions. However, passing stress tests can also create a false sense of security because of what it is not.

Regulatory reforms always start out with well-meaning intentions. However, unless new regulations address the root cause of the problem requiring reform, and interests of all parties are aligned, they are not just less than effective. They can have unintended consequences resulting in greater complexities that actually end up increasing risk. Are we beginning to see some such effects with the recent regulatory reform? The following article from last Sunday’s (April 20, 2014) New York Times may be of interest along these lines.